British chaos means interest rates will stay low for longer

By DAVID McHUGH and MARTIN CRUTSINGER

Published 11:37 am, Wednesday, June 29, 2016

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British chaos means interest rates will stay low for longer

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FRANKFURT, Germany (AP) — Savers will suffer longer with zero returns on their accounts. Home buyers, companies and governments will keep on borrowing cheaply. And questions will grow further about whether central banks are creating bubbles in financial markets by keeping interest rates near or below zero.

The British vote to leave the European Union shook up markets and lowered growth forecasts for Britain and, to a lesser degree, the other 27 members of the European Union. Economists say that means central banks are likely to have to keep in place for even longer their massive, extraordinary stimulus efforts that have helped keep the global economy afloat in the wake of the 2008-9 financial crisis. Some central banks might even have to unveil new stimulus or rate cuts.

Here's a look at how the fallout from the British vote will affect interest rates around the world.

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LEHMAN, OR NOT

What this isn't: a "Lehman moment." That is, a crisis like the one that followed the collapse of U.S. investment bank Lehman Bros. in 2008. Back then credit markets froze and central banks had to step in aggressively to keep the financial system functioning.

Last Thursday's vote certainly sent markets lower, but nothing like the drops seen eight years ago.

"This is not a Lehman," said Holger Schmieding, chief economist at Berenberg Bank. "It is a significant re-pricing, but financial markets are not seizing up."

In part, that's because many of them have already poured, or are still pouring, tons of stimulus into their economies. The ECB has cut its main interest rate to zero and is pumping 1.74 trillion euros ($1.93 trillion) into the banking system by purchasing government and corporate bonds with newly printed money. The U.S. Federal Reserve, the Bank of Japan and the Bank of England had earlier carried out similar programs and cut rates to or near zero.

The impact is more one of duration. Investors are pushing back expectations of when interest rates will rise back to more normal levels. That means savings and pension funds will continue to grow only very slowly as their returns are often tied to the official interest rates set by central banks. Conversely, loans will remain cheap for businesses, home buyers and governments.

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EUROPE, GROUND ZERO

Forecasts for interest rates have dropped most dramatically in Britain as the country will bear the biggest economic damage from its exit from the EU. Business investment is expected to suffer as the country is forced to redefine its trade relationship with its biggest export market, the EU, where it currently enjoys free trade. Businesses could leave or move production.

The Bank of England had until before the vote been expected by some analysts to increase its benchmark interest rate this year. Now it is forecast to cut it from 0.50 percent and some even think it could have to start injecting new money into its economy.

In the 19-country eurozone, of which Britain is not a member, the ECB could act if the economy falters seriously.

It could extend its bond-buying stimulus program, which aims to push down market interest rates, beyond the current March end date. That's something the bank has already made clear it will do if needed. It has also said its benchmark lending rate — currently zero — will remain low long after the bond purchases stop.

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FED IN HANDCUFFS

In the United States, the expectation had been that the Fed could raise rates twice this year, with the first hike occurring next month. However, economists now say a Fed rate hike is off the table, not only for the next meeting but for the rest of this year.

"The Fed is handcuffed at the moment," said Diane Swonk, chief economist at DS Economics in Chicago. "You have got a lot of things moving in the wrong direction in the view of the Fed because of the vote in Britain."

The Fed is not only concerned about stock market volatility but other fallouts from the British vote, including a further rise in the value of the dollar, which could hurt U.S. exports and further slow the American economy, and falling oil prices, which could worsen the slowdown in the U.S. energy sector.

Many economists have lowered their U.S. growth forecasts by this year by as much as a half-point, now predicting the U.S. economy will likely manage growth of perhaps 1.9 percent this year, with further weakness in 2017.

Swonk said if markets stabilize and Britain and the EU show evidence of resolving differences over an exit plan, the Fed might begin raising rates again in the first quarter of next year.

Other economists believe the Fed will remain on hold for much longer.

"The Fed is looking at potentially years of uncertainty. This will hurt consumer spending and capital investment in the United States," said Sung Won Sohn, an economics professor at California State University, Channel Islands. "I would put it pretty close to zero probability that we will have a hike in interest rates this year or next year."

As expectations for a rate hike diminish, rate for 30-year fixed mortgages have fallen from over 4 percent in July 2015 to 3.60 percent this week.

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DIMINISHING RETURNS

As central banks appear ready to keep rates lower for longer, some voices argue that they are reaching the limits of what they can do.

The Bank for International Settlements — a forum for the world's central banks — has warned that the effectiveness of low rates diminishes and risky side effects increase the longer interest rates are kept low.

"To have a big impact on yields and prices, easing must generally surprise markets," the bank said Sunday in its annual report. "But surprising them becomes harder once they become used to large doses of accommodation: the bar rises with every measure taken."